Hiring so-called founders at startups: What went wrong with the global model of incubation

As per analysts, it had more to do with the so-called founders not having enough skin in the game to want to stick by and lead their cos through thick and thin.Madhav Chanchani&Payal Ganguly | ET Bureau | September 02, 2016, 08:06 IST

Startup factories had seemed a great concept. These incubators were launched by business groups with experience or interest in sectors such as telecom, media and internet.Not five years ago, an online retailer called FashionAndYou was considered a better bet than Flipkart. The one-year-old firm owned and operated by business incubator Smile Group had raised $40 million in October 2011, becoming the most well-funded startup in India’s nascent online retail market. Overall, it had racked up $48 million from marquee Silicon Valley venture capital firms Sequoia Capital and Norwest Venture Partners as well as the investment arms of chipmaker Intel and Finnish phone maker Nokia. Flipkart, launched in 2007, had raised $30 million.

"We have been passionate supporters of the growth of ecommerce in India and FashionAndYou has clearly emerged as one of our best portfolio companies," Smile Group founder Harish Bahl said in a statement then. Smile’s portfolio of nearly half a dozen companies included Dealsandyou, Freecultr and Bestylish, which had mopped up nearly $120 million from VC investors.

Fast forward to 2016: FashionAndYou’s investors have written down the money they put into the company. Its chief executive has quit. And Bahl is seeking to salvage and revive Smile’s portfolio companies.

Smile Group along with German incubator Rocket Internet and Malaysia’s Astro Group are among a small band of startup factories that sought to cash in on India’s ecommerce gold rush at the beginning of this decade. They launched a slew of companies, hired executives they called "founders" to run the businesses, and in all funneled $800 million-$900 million into their portfolio firms.

Now, these incubators are staring at the dim prospect of making a mere few cents on each dollar invested.

A case in point is online fashion retailer Jabong, in which Rocket Internet and Sweden’s Kinnevik invested more than $275 million. Eventually, a struggling Jabong had to be sold to bigger rival Myntra in July for $70 million, returning 25 cents on each dollar invested. Those involved in the transaction said it was a better-than-expected outcome.

In 2014, Jabong entered into sale talks with Amazon but the discussions unravelled over its asking price of more than $1 billion. Its struggles with a slew of management changes and slowing sales growth eventually forced its sale to Myntra at a much lower price.

Startup factories had seemed a great concept. These incubators were launched by business groups with experience or interest in sectors such as telecom, media and internet. They would zero in on business ideas that had become successes in global markets such as the United States and hire executives to replicate those in India. Many of these businesses are struggling, though, and a big portion of the blame is being laid on the incubators.

Clearly, the problem with these startups was not a lack of capital. As per several analysts ET spoke with, it had more to do with the so-called founders not having enough skin in the game to want to stick by and lead their companies through thick and thin.

Rocket Internet typically holds 90-95 per cent of the equity in its portfolio companies, allowing its founders and other top employees a 5-10 per cent stake. Also, in many of these companies, there was a perennial revolving door of CEOs/cofounders.

Smile Group’s Bahl "believed he will get a new and better set of people who can run FashionAndYou. The next wave was consultants who came in but none of them could scale these ventures," said Rahul Narvekar, the first CEO of FashionAndYou.

Narvekar graduated from the Indian Institute of Management-Calcutta and worked at real estate companies Ansal API and DLF Group before joining FashionAndYou as cofounder.

Venture capital firms were betting on Smile Group to replicate its success with media companies Quasar, which was acquired by advertising firm WPP in 2007, and SVG Media. Bahl had also gained a reputation for helping home-renting company Airbnb, among the world’s most-valued startups with an estimated worth of $30 billion, expand globally.

Bahl conceded that the incubation model has proved a failure. "We thought if we give higher stakes to founders they will do a better job," he said, but they typically lacked the passion an entrepreneur brings. "There is a structural confusion in this model about whose company is it," Bahl said.

"Inherently, the model has some chinks as you can’t hire entrepreneurs and give them a business to execute. Entrepreneurs naturally get excited by an idea and a big problem and want to solve it," said Vikram Vaidyanathan, managing director at venture capital firm Matrix Partners India. "Secondly, the value creation is too skewed for those who are not creating and running the business, and high quality professionals do not see enough upside in staying with these companies."

The most high-profile of Rocket Internet’s India ventures were Jabong and online food delivery service Foodpanda. None of the original managing directors or cofounders of these companies are around anymore.

Cofounders Manu Jain and Lakshmi Potluri quit Jabong in early 2014 and in 2015, Arun Chandra Mohan and Praveen Sinha also quit. Two of Foodpanda’s cofounders, Amit Kohli and Akhilesh Bali, quit within two years, by 2013, and Rohit Chadda left in August 2015, soon after which allegations of corporate fraud started flying.

Investors who have evaluated Rocket Internet companies for funding say they were not comfortable with the shareholding structure. "How do you invest in a company where an investor sitting in Germany holds a 90 per cent stake?," one such investor said, declining to be identified.

Several people who have worked with Rocket Internet say the Samwer brothers, who run the firm, underestimated the vibrancy of the venture capital and entrepreneurial ecosystem in India. While in Europe and Southeast Asia the company did not face much competition, India was a different case.

"They did not understand that aggressive spending of marketing dollars alone will not work in India. And the teams here needed much more autonomy," said a former Rocket Internet cofounder, also requesting anonymity.

For its global fashion portfolio, Rocket Internet formed an umbrella entity called Global Fashion Group in 2014, causing a strategic disconnect for Jabong’s top executives.

"The direction of GFG was profitability while India’s vision was growth for Jabong. These kinds of structural decisions cannot be taken by hired founders if the board has decided and you are a minority shareholder," said ex-Jabong CEO Praveen Sinha, one of the longest serving cofounders at Rocket Internet.

What has also dogged several of these ventures are allegations of cash mismanagement and financial wrongdoing. Rocket Internet and Kinnevik had conducted a forensic audit on Jabong, which found corporate governance violations by its top management, including by Sinha, Mohan and Rocket Internet India managing director Heavent Malhotra. Sinha has denied any wrongdoing.

Astro intends to appoint a forensic auditor to review the books of Getit, the owner of online retailer Askme Bazaar in which Astro is the majority investor with a 98.5 per cent stake, because of performance issues.

In a statement, Astro said it will "take appropriate steps based on the results of that audit." Meanwhile, vendors of Askme Bazaar approached the Economic Offences Wing last week to register a case against the company alleging non-payment of dues.

FashionAndYou, too, went through an audit following suspected financial wrongdoing. Auditors and investors gave the company a clean chit.

"Stories about wrongdoing and accounting scandals used to be associated with brick-and-mortar companies and hardly with technology companies. It is a giving a bad name to the startup ecosystem," said Rajesh Raju, managing director at VC firm Kalaari Capital, which has backed ecommerce companies Snapdeal and Myntra.

For all this, at least one startup factory in India is having some success. Entrepreneurs and investors say that GrowthStory, led by husbandand-wife duo K Ganesh and Meena Ganesh, has had some success with companies like India’s largest online grocery Big Basket but it was too early to judge. Eight startups that GrowthStory has helped launch, including jewelry retailer Bluestone and home healthcare services provider Portea, have collectively mopped up $350 million in funding from venture capital investors since 2012.

What works in their favour are the relatively higher stakes the founders hold and greater operational involvement, according to three investors who have put money into GrowthStory companies.

"We come up with an idea and some amount of market research and then onboard cofounders who own 50 per cent stake in the company. This ensures enough skin in the game," said K Ganesh. "The way we are different from a Rocket Internet is not because we are Indian cofounders and investors but the fact that we have cofounders, not employees, with stock options."